Roadmap to stronger, sustainable growth

This post is a guest contribution by Richard Berner & David Greenlaw of Morgan Stanley.

Breakthrough tax deal. We assume Congress will approve the tax/fiscal stimulus deal, which will add about 1pp to growth in 2011 relative to our earlier baseline, pushing our forecast to 4% over the four quarters of next year. Implementation of the deal, which could begin on January 1, will shift the mix of stimulus from monetary to fiscal policy, so that the Fed will likely be less inclined to extend the current LSAP program beyond 2Q11. And it suggests that yields will gradually continue to move higher, to 4% by end-2011.

As widely discussed, the deal will extend the expiring income tax cuts for all taxpayers for two years. In addition to extending several other expiring provisions, it includes three key temporary elements which add new stimulus – a one-year payroll tax holiday for employees, a 13-month extension of emergency unemployment benefits, and full expensing of business investment outlays for 2011. These will boost growth in 2011, partly at the expense of 2012. We estimate that their expiration at end-2011 will net to an offsetting drag of about 0.5pp in 2012. Together with other expiring provisions, the new stimulus amounts to about $400 billion above our December 3 baseline assumptions over 2011-12, or about 1.3% of GDP in each year. We illustrate the estimates of the budget impact of all provisions; these are similar to what we published last week, but refined by the Joint Committee on Taxation and Congressional Budget Office.

Why should this plan have more bang for the buck than ARRA? The fiscal stimulus enacted in the American Recovery and Reinvestment Act (ARRA) of February 2009 (Pub. L. 111-5) did not seem to add much oomph to the economy relative to its size; why should this smaller one produce more results? In our view, there are two reasons. First, the nature of the stimulus matters: Most of the latest stimulus (about 0.7pp) results from the new proposed payroll tax holiday for employees. Such cuts accrue mostly to lower-income, budget-constrained taxpayers and show up quickly in spendable income, so they are more likely to be spent.

In contrast, the Making Work Pay (MWP) tax credit that was a key part of ARRA was disbursed slowly, and some empirical work suggests that taxpayers spent only about 13% of the incremental income, which partly showed up in withheld taxes and partly in rebates when taxes were filed. Similarly, consumers spent about one-third of the one-time tax rebates in the 2008 stimulus package. In addition, the MWP credit at $60 billion was smaller than the proposed payroll tax holiday. Likewise, while ARRA’s grants to states and healthcare insurance premium (COBRA) assistance provided a helpful buffer for governments and individuals, these funds tended to be saved rather than spent. Finally, outlays for the famously ‘shovel-ready’ infrastructure projects featured in ARRA took as much as a year to show up in spending.

A second reason why the current stimulus is likely to be more potent involves the state of financial conditions affecting households: We believe that liquidity-strapped consumers, suddenly denied access to borrowing in the credit crunch, were more likely in early 2009 to save their tax credits and other forms of stimulus or use them to pay down debt. In contrast, the deleveraging process for households and lenders is far more advanced today.

Indeed, four factors already are promoting sustainable growth. First, balance sheet healing is more advanced and, courtesy of the Fed’s new asset-purchase program, financial conditions are gradually becoming easier. Debt-to-income and debt-service-to-income ratios continued to decline in 3Q. The Fed’s Senior Loan Officer survey indicated that banks’ willingness to lend to consumers has continued to improve and that banks have eased lending standards for consumer loans. The glaring exception is that mortgage credit is still tight; indeed, in 4Q banks signaled tighter standards for mortgage lending. And the ongoing issues around mortgage ‘putbacks’ continue to keep origination criteria from loosening.

Second, stronger global growth finally seems to be boosting US output. Following a period in which surging imports overwhelmed domestic demand, and net exports depressed GDP by 3.5 and 1.8pp in 2Q and 3Q, respectively, we expect a sharp reversal in 4Q, with net exports contributing 3.2pp of the estimated 4.3% growth in that quarter. Some of this volatility is statistical, as Dave Greenlaw and Ted Wieseman will demonstrate in a forthcoming note. But much is fundamental, as hearty growth abroad and slower growth in US domestic demand augur a narrower trade gap.

Third, the time-honored cyclical dynamics of recovery, delayed by the credit crunch and the legacy of the financial crisis, are finally promoting the hand-off from rising output to increased hours, employment and income. While November’s employment canvass was disappointingly weak in nearly every respect, including a downtick in the workweek, a broader perspective shows that rising hours have supported moderate gains in wage and salary income, and the improvement in a variety of labor market indicators – declines in jobless claims, rising job openings and surveys of hiring plans – points to renewed job gains. Finally, pent-up demand for capital spending is healthy; in the recession, capex slipped well below depreciation expense. Together with the acceleration we expect in economic activity, and the business expensing provisions of the new tax deal, that pent-up demand should spur hearty gains in capex in the coming year. And we think that improving fundamentals will boost capex outlays in 2012 despite the inevitable ‘payback’ in outlays after the tax expensing provision expires.

Bottoming in inflation soon, gradual rise coming in 2011. Two factors should promote a bottoming in inflation soon and a gradual rise in inflation over 2011-12: 1) higher inflation expectations courtesy of the Fed, and 2) an acceleration to slightly above-trend growth that narrows slack in the markets for goods, services and housing. The continued slide in core inflation through October to 0.6% in terms of the CPI and 0.9% as measured by the Fed’s preferred gauge (the PCE price index) leaves it well below the Fed’s comfort zone. While the Fed doubtless welcomes the rise in market-based inflation expectations, it’s not sufficient to make officials comfortable with the inflation outlook; indeed, the FOMC’s central tendency of only 1.3% core inflation in 2012 and 1.6% in 2013 strongly suggests that it isn’t thinking of an exit strategy from the current policy stance any time soon. Taken at face value, the FOMC’s inflation outlook implies a ‘tighter’ relationship between inflation and slack in the economy than does ours; we expect a faster, albeit gradual rise in core inflation to 1.5% over the course of 2011.

Four downside, two upside risks. Despite these supportive factors, there are four key downside risks to the outlook for growth. Most are familiar. First, housing imbalances remain the most significant single downside risk; a decline in home prices larger than the 10% we expect would disrupt further the supply of credit, menace consumer balance sheets, and thus threaten consumer spending. Second, state and local government finances remain fraught; faced with additional shortfalls, officials might cut spending and employment significantly further, especially as federal grants fade. The good news is that revenues are starting to improve, which should mitigate that risk. Third, if Europe’s sovereign crisis were to intensify further, it would (as in the spring) promote renewed risk-aversion and tighter financial conditions. Finally, if China’s monetary policy tightening were to go beyond the three additional moves we expect, it could trim market expectations for future growth.

Conversely, two forces might promote upside risks to our still-moderate growth scenario. First, a stronger global economy, especially if it shows up in US exports, could boost growth significantly. Second, a persistently weaker US dollar could accelerate that process – one that we expect will play out in the next two years in any case.